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Preserving Amortized Costs within a Fair-Value-Accounting Framework: Reclassification of Gains and Losses on Available-for-Sale Securities upon Realization

University of California, Berkeley; China Academy of Financial Research (CAFR)

November 1, 2010

Abstract:

SFAS No. 115 requires firms to recognize available-for-sale (“AFS”) securities on the balance sheet at fair value with accumulated unrealized gains and losses (“AUGL”) recorded in accumulated other comprehensive income (“AOCI”), a component of owners’ equity. Firms reclassify AUGL to net income when they realize gains and losses. We refer to the amount of this reclassification each period as “RECLASS.” Beginning in 1998, SFAS No. 130 requires firms to present the components of comprehensive income, including RECLASS, prominently in their financial statements.

For a sample of 200 large U.S. commercial banks from 1998-2006, we examine the incremental value relevance of RECLASS beyond AUGL and other components of book value of equity and comprehensive income. Employing a levels valuation model, we find the coefficient on RECLASS is significantly positive and closer to the coefficient on the relatively permanent net income before extraordinary items and discontinued operations than to the coefficients on AUGL and more transitory components of book value and comprehensive income. We find this high value relevance for RECLASS despite also finding that investors assess at least a normal amount of value relevance to AUGL. We interpret these findings as implying that investors assign value relevance to the realization of previously generated unrealized gains and losses.

Our findings regarding the value relevance for RECLASS are markedly stronger than those of Barth (1994) and to a lesser extent Ahmed and Takeda (1995) for realized gains and losses for sample periods ending prior to the issuance of SFAS No. 130. This difference is consistent Biddle and Choi (2006) and Chambers, Linsmeier, Shakespeare, and Sougiannis’ (2007) findings that the value relevance of comprehensive income increases after the issuance of SFAS No. 130. We interpret our findings as implying that the FASB should continue to require prominent financial statement presentation of realized gains and losses, an amortized cost accounting construct, within the fair value accounting framework for AFS securities. This implication has high current salience, because in May 2010 the FASB has proposed dual presentation of the amortized costs and fair values of many financial instruments on the balance sheet.

We conduct four analyses to investigate possible explanations for the incremental value relevance of RECLASS. First, we find RECLASS is more value relevant for banks holding more liquid securities, inconsistent with investors focusing on RECLASS because of unreliably measured AUGL. Second, we find RECLASS is more value relevant for higher growth banks, consistent with realization of gains and losses interacting with or indicating future bank growth. Third, further supporting the growth explanation, we find RECLASS is significantly positively associated with one-year-ahead comprehensive income controlling for other components of book value and comprehensive income, more so for banks holding more liquid securities and growing faster. Fourth, we find relatively weak evidence of market mispricing of unrealized gains and losses, in part because investors do not fully incorporate the association of unrealized gains and losses with future RECLASS.